Thursday, October 28, 2010

Capital controls will follow the weak dollar

by Michael Hudson

Financial Times (October 19 2010)

Two weeks ago Brazil moved to deter speculators from pushing up its currency, doubling the tax on foreign investment {1} in its government bonds. Last week Thailand acted on similar lines by no longer exempting foreign investors from paying a tax on its bonds, with the Thai finance minister warning of more to come. As the dollar falls and developing nations see speculators push up their exchange rates, other countries are also discussing more stringent restrictions. A damaging age of capital controls seems likely.

Indeed, moves by speculators purchasing assets and taking currency positions in China, Brazil and much of Asia now threaten to make this new era a self-fulfilling prophecy. Such speculative inflows contribute little to capital formation or employment. But they do price exporters out of foreign markets, and can be suddenly reversed if speculators pull out, disrupting trade patterns.

With the likelihood of further falls in the dollar, central banks in developing countries face a capital loss if they try to stabilise exchange rates by buying dollar-denominated assets - as the Bank of Japan did when it recently bought $60 billion of dollar securities {2} to hold down the yen's rise. These modest acts set rates through the open market, but their cost is now threatening to drive these economies towards more formal capital controls.

Such a trend would be grim news for the US, but its financial policymakers have only themselves to blame. By lowering interest rates to almost zero and giving clear hints of another imminent round of quantitative easing {3}, the Federal Reserve is providing speculators (and the banks) with yet more cheap credit - much of which is being used to speculate against the dollar.

The problem is that "QE2" will quickly spill over into currency markets, prompting foreign defensive moves to defend against currency raids that push up exchange rates against the dollar. Easy credit policies in the US and Japan will further fuel speculation in the currencies of developing economies in strong balance-of-payments positions. And the largest speculative prize of all remains an anticipated upward revaluation of China's renminbi, followed by other Asian currencies.

Here we see echoes of the 1997 Asia crisis, but in reverse. That period of panic saw speculators swamp developing markets with sell orders, emptying the central bank reserves of countries that tried to keep their exchange rates stable. Today, these same countries are those likely to find capital controls attractive, but this time they are blocking speculators from buying their assets and currencies, not selling them. The economies targeted by speculators are now those that are strong, not ones that are weak.

Developing nations are thinking seriously about how to use controls to protect themselves. Malaysia led the way in 1997, by blocking sales of its currency. In recent weeks it is Chinese officials who have been discussing tactics to isolate their financial markets from further dollar inflow. The simplest way would be for them to stop exchanging renminbi for dollar payments for non-trade transactions. This would lead, in effect, to a dual exchange rate - one for trade and another for financial transactions - a common arrangement from the 1930s into the 1960s.

The real threat is a world broken into two competing financial blocs, one centred on the dollar, the other on the Bric nations of Brazil, Russia, India and China. Tentative steps in this direction occurred last year when China, India and Russia, along with Iran and members of the Shanghai Co-operation Organisation took early steps to use their own currencies for trade, rather than the dollar. China took a simpler path last month when it supported a Russian proposal to start direct trading using the renminbi and the rouble. It negotiated similar deals with Brazil and Turkey.

To deter this the US and Japan should refrain from QE2, even at the cost of lower US growth. An even better response, however, would be new regulations stopping western banks from speculating in foreign currencies, by using heavier reserve requirements or a short-term tax on foreign currency trades and options. Without such steps other countries will soon move to protect their currencies. If they do it will have been US policy short-sightedness, conducted without concern for its effect on developing economies, that will ultimately have isolated the dollar and its users.